Wednesday’s  New York Times is barely liftable under the weight of a 13,000 word article charting the financial legacy of New York developer Fred C. Trump.

Trump (who died in 1999 at the age of 93) is best remembered outside the five boroughs of New York as the father of the 45th president of the United States. Within those boroughs (and perhaps within the hallways of the Internal Revenue Service and the U.S. Department of Justice) he is legendary, a man equally gifted at amassing a fortune in real estate and then bending his affairs into whatever shape was necessary to avoid (some would say “evade”) income, gift and estate taxes.

When pigs avoid slaughter

There are many aspects of the Times story that will evacuate your soul, particularly the company invented by the family that did nothing but mark up purchases made by other family-controlled operations as a way to defraud customers and the government. But for the purposes of this article I will only look at one: the Trump family’s use of grantor retained annuity trusts (“GRATs” in the financial vernacular) to pass on assets to younger generations while avoiding estate or gift tax.

GRATs have been around for generations. They are generally well understood within the tax system (the IRS, courts and practitioners alike are familiar with them) but they rely on proper representations as to what exactly is being transferred. We have used them for clients and will likely continue to do so under present law.

How does it work?

To see how a GRAT works and what it can do, let’s create an example.  Let’s think of a family real estate business, run by dad (I don’t know, let’s call him “Ed”) and his son, “Ronald.”

Ed owns an office building. He invested real cash to buy it, but also has a mortgage.  If Ed were to sell the building today he would want to get at least $10 million. Since he has a $8 million mortgage his equity in the property is $2 million.

Ed doesn’t own the building outright in his own name.  The building is owned by Ed’s Office LLC. Ed owns 100% of the LLC and is the manager. This is completely normal, so far.

Ed knows that if he dies owning the LLC and wants to leave it to his son Ronald there will be a stiff tax to pay. In Ed’s era this tax was 55%. Today it’s 40%, but that’s still a big number here. The value of the LLC interests should be $2 million ($10 million building, minus $8 million in debt which doesn’t count for transfer value).  55% of that is $1.1 million, which makes dying an even less-palatable option than normal for Ed (and for Ronald, who wants to inherit this asset and would just as soon keep the $1.1 million, thank you).

So Ed goes to his lawyers and says he wants to cut his tax bill. His lawyers say “No problem!” And thus the GRAT is born. In it, Ed creates a trust (a GRAT is just a trust at its core) with Ronald as the ultimate financial beneficiary, and transfers some (but not all) of his LLC interests into the trust. Has he made a gift to Ronald? No. The reason he has not made a gift is that he gets something in return for it: an annuity. Unlike the annuity that most people know that pays money for the rest of your life, this annuity only pays Fred for a period of time, sometimes as little as two years.  It also has to pay a legally mandated interest rate on top of that.  If Ed puts half of his LLC interests into the GRAT the transaction looks like this. Let’s pretend the interest rate is 4% and the period is two years.

• Inception: Ed puts 50% of the LLC interests (worth $1 million in our example) into GRAT.
• Anniversary 1: GRAT pays Ed $500,000 principal plus $40,000 interest.
• Anniversary 2: GRAT pays Ed $500,000 principal plus $20,000 interest.

Ed now has some cash, and the GRAT has the LLC interests free & clear. Ronald really likes that any future appreciation of this asset belongs to the GRAT, not to Ed. This is a huge reason why wealthy people put assets into GRATs: it moves all the future growth of the asset outside their estates.

But it doesn’t seem like anyone got away with anything. It’s two years later, and this whole deal looks like a big nothing-burger. Each side seems like it got fair value for what it gave. How are we going to make this financial transaction worth all this effort?

<Enter the lawyers, the accountants and the appraisers>

The first step is to make the property in question as worthless as possible on paper. Remember our $10 million building? Step 1 is to get a friendly appraiser to state that the building is not quite up to snuff at the moment, maybe say it’s worth $9 million.  This may be a lie, but unfortunately unless there is an arm’s-length sale it’s impossible to know what any property is really worth, so it’s just a matter of opinion at this moment.  As lies go this is probably a small one. But if you watch closely you can see all the little lies start to add up.

So now Ed’s building owned by his LLC is worth $9 million on paper.  Of course, Ed didn’t put the building in the GRAT, he put the LLC interests. After the mortgage, they should be worth $1 million in total, right? Wrong.

LLC interests are not created equally. Remember when we said Ed was the manager? LLCs are run by their managers, not the owners. As long as Ed made himself the only manager, he is the only one who decides what the LLC does or does not do. All the other LLC holders are merely passengers on the bus: Ed’s the only one at the wheel.

So these interests are worth less because they lack control. Let’s say this knocks 20% off their value. Another financial appraiser will be hired to state this is the case. He will write a very official looking (and heavy!) document that says so in painstaking detail. And he’s probably right! No one would pay full, fair market value for an asset if it were controlled completely by someone else.

To bring you up to speed, our $2 million in equity became $1 million because the building appraised lower, which turns my $ 1 million transfer into a $500k transfer. Now, my lack of control discount turns a $500k transfer into a $400k transfer.

Does that cut the tax bill enough? Not remotely!

But the discounts are only getting warmed up. Another discount is taken because the GRAT cannot do anything with these LLC interests in the trust. It can’t sell them, it can’t pledge them as collateral to borrow cash. All it gets to do at this point is stare at this shiny sports car in the garage: it does not get to drive it. Send in the next appraiser!

Now another appraisal report says that because of this lack of marketability (as it’s called in the trade) the LLC interests may be worth 30% less than their otherwise fair market value. Another heavy document is prepared.

Stack up these discounts, and we just knocked another 50% off the stated transfer value. We turned a $1 million transfer into a $500k transfer into a $250k transfer.  Now the math looks like this:

• Inception: Ed puts 50% of the LLC interests (worth $250k post-appraisal) into the GRAT.
• Anniversary 1: GRAT pays Ed $125,000 principal plus $10,000 interest.
• Anniversary 2: GRAT pays Ed $125,000 principal plus $5,000 interest.

Remember, it’s the same building with the same tenants and the same cash flow in both examples. We still passed half the value of the building’s equity. We just made the value of the LLC interests drop 75%. The camel has walked through the eye of the needle.

But back to Fred Trump and his desire to pass wealth to his children without paying estate or gift tax. Take the above example I just gave and multiply this by the dozens of buildings owned and controlled by Fred Trump in his 93 years of living and you get some idea on the value that was passed to his children free from estate or gift tax.  How does this happen? Take a law that is purposefully vague and push it to all extremes by an army of professionals incented by wealthy people to do so, that’s how. Be willing to lie at every stage of the process, knowing the other side doesn’t have the resources to suss out all of the lies.

How do we really know all of these are lies?

It’s simple, the Trump family told us they were.

$41 million of apartment buildings (as stated by the appraisers in Fred’s 1995 gift tax return) were worth $900 million less than a decade later when the family’s assets were put up for sale.

There’s an old saying in investing: bulls can make money, bears can make money: pigs just get slaughtered. It’s usually true, except when it isn’t.